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Good intentions, perverse incentives

The current financial crisis and boring, defensively played, football matches may seem to have little in common, but according to LSE Professor Luis Garicano both can be understood as failures of the same underlying mechanisms.

In a new short film produced for The Independent newspaper's website, Professor Garicano uses the theories of organisational economics to describe how people react to incentives - and how their behaviour can often differ from the intended effect of the incentive.

He points out, for example, that the financial system is driven by an incentive structure that encourages and rewards traders for behaviour which is ultimately detrimental to the health of the economy.

He says: 'It's clear that bankers were being rewarded for taking excessive risks. The short term nature of their pay - whereby bonuses are accrued over a year - encourages short term, risky decision making. This has to change. Bonuses need to be accrued over longer periods - three or five years. This would mean that if you do something crazy that ends up making you a lot of money this year but, because it is crazy, ends up losing the bank money in 5 years time, you will not benefit from it.'

Professor Garicano explains how people behave rationally when faced with incentives: 'If I take a big risk and borrow a maximum amount of money, for example, I buy £100 million of something, if it goes up and I make £200 million I get a share of that. However, if it goes down the worst that can happen is that I get fired - which is obviously bad but not as bad as £100 million extra would be good.'

Professor Garicano also describes FIFA's failed attempt to encourage more goal scoring in football matches as the result of players responding in unforeseen ways to incentives.

Football matches are generally low scoring with small goal differences. In part, this is because games are played as a tense stand off where every push for goal involves taking men forward and thus weakening the defence, increasing the chances that the attacking team will concede a goal.

In 1994, FIFA tried to encourage more attacking and exciting football at the World Cup by increasing the number of points a team were awarded for a win, from 2 points to 3 points. The points for a draw or a loss remained at on 1 and 0 respectively. It was thought that if a team stood to win a greater marginal win by winning rather than tying, they would be eager to score more and quicker.

However, the actual effect of the incentive was to encourage attacking football only up to the first goal after which the games became, if anything, duller still. Although there was considerable gain in being ahead - a three point lead in the tournament - the marginal cost of conceding a goal once you were ahead was also much greater as the score for a tie was still one point and the equaliser would rob the team of 2 points.

Professor Garicano explains: 'What happens in league games is that you do get more attacking football when the score is at 0-0. Teams are more entrepreneurial and are trying to create more opportunities with more forward play. However, once one of the teams scores, that team becomes more defensive and the football becomes more calculated. By increasing the punishment for a goal scored when you are slightly ahead you also increase the incentive to play ugly football.'

You can see the film at:
http://www.independent.co.uk/opinion/commentators/luis-garicano-incentives|
-can-explain-everything-1545747.html| 

Ends

For more information contact: Sue Windebank, senior press officer, LSE, at s.windebank@lse.ac.uk| or on 020 7849 4624

Notes for editors

This short film forms part of the Big Ideas series produced by LSE in conjunction with Robin Powell, a freelance journalist for Sky News and The Politics Show on BBC1, and a director of Ember Regis. The company is a pioneer in the field of internet television and produces high-quality video content for a range of private and public sector clients and for all the major UK broadcasters.

4 January 2009

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